Depositors who need ready access to deposited funds often utilize demand deposit accounts (DDA's) such as checking accounts. Although DDA's allow relatively unfettered access to funds, they also have significant shortcomings. The return on funds kept in DDA's is often limited because many DDA's pay little or no interest on account balances. Also, financial institutions are limited in the way that they can use funds deposited in DDA's because of the associated liquidity risk: a depositor may have the right to remove any or all of the deposited funds at any time to pay for a transaction, or for any other reason. Moreover, the low interest rate paid on a typical DDA does not create a significant incentive for the depositor to keep funds in the DDA. From the standpoint of the financial institution, this makes the balances of DDA's highly liquid. Therefore, financial institutions are often prevented from using DDA deposited funds in longer term investments, and thereby lose the opportunity to pursue the potential return that such investments might provide.
The problems associated with DDA's often force depositors who want to earn a higher interest rate to transfer funds from a DDA to a higher interest-bearing account when the funds are not needed in the DDA to cover transactions. This approach, however, only creates additional difficulties. It can be appreciated that a considerable degree of cash flow management is required on the part of the depositor to calculate what portion of an account balance may be transferred at any given time and to move that balance between accounts. In addition, mistakenly calculating the required balance in the DDA, or not transferring sufficient funds from the higher interest-bearing account back into the DDA, may cause costly overdrafts on the DDA.
Many banks automate fund transfers by offering sweep accounts, however, these accounts also present their own problems. Typically, a sweep account includes two physical accounts, a DDA and an associated investment account (e.g., a money market account). After all daily transactions have cleared the DDA, some portion of its remaining balance is transferred to the investment account where the funds may earn interest until the opening of the next business day. At that time, the funds are transferred back to the DDA. It will be appreciated that it requires substantial administrative resources and information technology infrastructure to maintain two accounts and transfer balances, as in a sweep account. Also, with many existing sweep accounts, one or both of the DDA and the investment account are not insured by the Federal Deposit Insurance Corporation (FDIC) or another insurance provider, thereby increasing the depositor's financial risk.
Accordingly, in view of the problems described above, there is a need for a DDA that can be structured to potentially increase depositor returns while reducing the liquidity risks for financial institutions that offer the DDA.